"Funeral celebrations" style violent price increases, is NetEase finally going to survive?

$NTES-S(09999.HK)$NetEase(NTES.US) released its Q3 2024 financial report after the Hong Kong stock market closed on November 14, Beijing time. Objectively speaking, the performance is under pressure. This is due to the lack of new products and the drag from old games affected by regulation and natural decay, two major reasons. Additionally, the high base from last year has made growth difficult this year.

However, the market's reaction after the earnings report seems to have experienced a violent surge, akin to "celebrating a funeral." What positive factors are hidden in the Q3 report? Dolphin Jun combined insights from the conference call, institutional discussions, and company meetings to discuss several core issues affecting NetEase's valuation, mainly focusing on the recent hot topic—gaming business.

First, Dolphin Jun's overall view:

Q3 was an unexpected performance under extremely conservative expectations, with the deviation from normal ranges due to:

On one hand, it reflects the market's low grasp of the operational cycle of gaming products. Although there are third-party data to monitor trends, for NetEase, where one-third of revenue from old games comes from official servers, external data is not accurate.

On the other hand, the market underestimated NetEase's ability to create operational miracles. For NetEase, the revenue trend over a short quarter or even half a year does not indicate much; there is more experience in revitalizing old games. However, the market's conservative deviation actually reflects a "relative preference." This year, NetEase happens to be in a tumultuous period, making it difficult for the market to avoid linear extrapolation given the series of setbacks at the beginning of the year. Coupled with the sharp increase in competition in the second half of the year and a deteriorating macro environment, it is challenging for the market to have a very positive expectation for NetEase.

This extreme pessimism, which raises doubts about long-term product strength, was also experienced by Tencent at the end of last year. Coincidentally, at that time, Pony Ma also cleaned up some product leaders who were "resting on their laurels." Currently, NetEase is undergoing its largest anti-corruption internal audit in recent years, benchmarking against Tencent, and is only missing a "DnFM" to restart.

However, objectively speaking, at present (at least in the short term for Q4), NetEase's game reserves are still very scarce, with mobile games being the main source of income. This is different from Tencent at the time; "DnFM" is poised for launch but only lacks a license. DNFM is a powerful engine for driving growth, but more importantly, it is a key banner for Tencent games to restart and rekindle market confidence in its long-term prospects. For NetEase, the key banner is still uncertain; the potential flagship project "Infinite" will begin testing in Q4, but the schedule for next year has not yet been determined. So without strong driving force for revenue, can NetEase sustain its valuation? The Q3 report gives us the answer:

(1) Release of operating leverage. From the operating expenses in Q3, we find that NetEase also has a high ability to adjust profits. The management expenses in Q3 significantly decreased, and although R&D expenses slightly increased, the costs for basic resources such as servers decreased year-on-year. This resource reuse "cost-cutting" style is still somewhat characteristic of NetEase.

(2) The charm of shareholder returns. Last quarter, Dolphin predicted that NetEase would continue to increase buybacks, assuming that the total buyback + dividends for the year would reach 18 billion RMB. The buybacks in Q3 indeed doubled, and although the dividends did not increase, if Q4 maintains the buyback intensity of Q3, the total shareholder return for the year is expected to exceed 20 billion, implying a 5% return rate based on the current market value of 54 billion USD.

Moreover, NetEase's ample cash reserves (reaching 120 billion in Q3) are also a key reason why Dolphin believes it can increase its investments at any time.

Overall, the poor macro environment (which has a greater impact on high ARPU NetEase games) + intense competition + lack of new products (mainly mobile games) + a tumultuous period, multiple negative factors have combined to create the current PE of 13x for NetEase and a 5% shareholder return. We won't speculate on when the real performance turning point will arrive (initially expected in Q2 next year), but in terms of current valuation safety, NetEase is indeed one. Therefore, for investors, there is no need to worry too much, just be a bit more patient.

1. How does Q3 performance compare to expectations?

Compared to the consensus expectations from BBG, NetEase seems to have performed slightly worse. However, BBG's expectations have always had a lagging issue, and for companies with significant short-term operational changes, institutional expectations are constantly being updated and adjusted, making BBG's consensus expectations less accurate.

Dolphin compared the latest expectations from leading institutions (updated at the end of October) and found them to be very conservative (this also explains the poor stock performance of NetEase since the 924 policy and why its valuation is at historical bottom levels). Under the extremely conservative expectations from institutions, NetEase's performance appears not so bad:

—— Here, Dolphin extracted Morgan Stanley's expectations, and compared to Morgan Stanley's expectations, NetEase's Q3 main game revenue significantly exceeded expectations, and it also exercised greater control over expenses to reduce the impact of revenue pressure on final profits. Ultimately, from the adjusted net profit perspective, there is a gap of 1.7 billion between expectations, with NetEase exceeding expectations by 20%.

Excluding investment income and foreign exchange gains and losses, the [operating profit from main business] achieved 7.15 billion in Q3, a year-on-year decline of 5%, but a quarter-on-quarter increase of 2% compared to Q2, which did not change the seasonal variation trend between peak and off-peak seasons.

II. Not discussing the expectation difference, how was the actual performance of the game in the third quarter?

Following the principle of picking bones in high valuations and finding highlights in low valuations. For the third quarterly report, Dolphin is mainly concerned about whether there are signs of a bottoming out and recovery in the adjustment of the gaming business.

First, looking at deferred revenue, the deferred revenue in the third quarter was 15.543 billion, a year-on-year increase of 9.5%, estimating the current period's revenue to be 22.1 billion, a year-on-year increase of 2%. Assuming the removal of the revenue from World of Warcraft and Hearthstone (based on the current confirmation ratio of 60%, we estimate a revenue of 1 billion), and the year-on-year increase of 200 million from the PC version of Naraka: Bladepoint, the remaining 20 billion, compared to last year's 21.6 billion revenue, indicates that the mobile game side only dragged down by 7-8%.

(1) PC Games: "Fantasy Westward Journey" has come back to life

The incident with Fantasy Westward Journey at the beginning of the year caused a short-term loss of users, as seen from the price of gold in the treasure pavilion, which dropped by 25% by September, and then began to stabilize. In the last quarterly earnings call, management also mentioned that from a monthly perspective, the revenue impact had bottomed out.

The third quarterly report also began to truly reflect that the adjustment of Fantasy Westward Journey has ended. Q3 PC games grew by 29% year-on-year, reaching 5.9 billion, with increments brought by the return of World of Warcraft (August 1) and Hearthstone (September 25). However, since the included revenue is not for a complete quarter, Dolphin estimates it to be 1/3 of the previous joint venture PC game single-quarter revenue (about 600 million) for this quarter.

In other words, excluding this 600 million, the remaining 5.3 billion, compared to last year's 4.6 billion in the third quarter, still shows a year-on-year increase. This includes the increment from the PC version of Naraka: Bladepoint (after the mobile game was launched, the dual-end linkage will drive revenue, as shown in the chart where user scale continues to rise), and on the other hand, it indicates that the decline impact of the largest proportion game, Fantasy Westward Journey (1/2~1/3), in the third quarter was not as significant as imagined.

（2）Mobile Games: Q4 remains a high-pressure period with a lack of new games, but the worst decline has already passed.

Of course, NetEase has faced bigger issues in mobile games this year. The third quarter is the season with the highest base, resulting in a direct year-on-year decline of 9.7% compared to last year.

Firstly, the old game "Egg Party" has imposed daily spending limits for all users due to upgraded protections for minors, which has led to a significant reduction in revenue, even though user retention has not dropped much and is still better than "Yuanmeng Zhixing."

Meanwhile, the mobile game "Nishuihan" has experienced a normal decline, with current monthly revenue possibly only at 1/2 or 1/3 of the same period last year. The launch of "Nishuihan" in the third quarter last year was stunning and made a significant impact, leading to considerable revenue over the following six months. This has created substantial pressure for the second half of this year.

Secondly, regarding new games, the launch of "She Diao" at the end of March was unexpectedly disappointing, barely maintaining a monthly revenue contribution of about 500-1 billion, followed by a steep decline. The company subsequently made deep adjustments and launched a new version in October. However, the competitive environment (after the summer battle of hundreds of games) and player mindset have changed significantly, and the new version did not bring a refreshing experience. Therefore, it quickly fell silent.

Subsequently, "Yanyun Shiliusheng" has been postponed to the end of the year for both platforms, and "Yongjue Wujian" has been delayed from Q2 to Q3. During the period from May to July, when competing major titles (such as "DNFM," "Juequ Zero," "Sanmou," "Mingchao," etc.) were frequently updated, NetEase remained silent. Then, throughout the summer, hundreds of new games were launched, and even though NetEase had "Yongjue Wujian Mobile," it was far from the unique advantage it had last year.

Currently, the mobile game pipeline has no new reserves for this year, so Q4 will still face high base pressure. However, compared to Q3, the base pressure is weakening, and "Yongjue Wujian Mobile" will contribute a full quarter of revenue, rather than just half a quarter in Q3. The user retention and revenue of "Yongjue Wujian Mobile" are currently stable, so we expect the decline in Q4 to be somewhat mitigated

III. Q3 Cost Optimization, Will NetEase Start a New Investment Cycle?

In the commentary on last quarter's financial report, Dolphin Jun judged that NetEase was about to enter a new investment cycle every 2-3 years to fill the product gap (especially in mobile games). However, in the third quarter, NetEase's operating expenses continued to decline by 1% year-on-year. So, will NetEase start a new investment cycle?

Dolphin Jun believes it will. The product gap has already had a huge impact on short-term performance. To meet the annual increase of 10%, or an additional net increase of 8 billion (assuming old games decline by 10% each year), it would require a revenue scale of 16 billion, which is currently difficult to support with a few self-developed mobile game projects.

However, a new investment cycle may not necessarily mean that short-term operating expenses will significantly increase. Instead, it is more about optimizing the non-core R&D employee teams from the perspective of efficiency and reducing R&D expenses by reusing basic resources and extending the lifespan of servers.

In the third quarter, management expenses decreased by 26% year-on-year, with equity incentives for operational management personnel also declining by 12%. R&D expenses only grew by 1.8% year-on-year in the third quarter, but equity incentives increased by 32%, indicating that the focus of optimization is not on R&D personnel but on other basic resource costs directly related to R&D, such as server depreciation.

Sales expenses in the third quarter also increased by 6.7% year-on-year, mainly due to the promotion of new games. However, as there are not many new games in the fourth quarter, this expense is expected to decline.

Ultimately, the core business operating profit that Dolphin Jun focuses on did not show a significant decline in profit margin compared to the previous quarter, which is much better than MS's expectations. The absolute value also reflects the growth trend from peak season to off-season.

IV. Doubling Repurchase, Significantly Increasing Shareholder Returns

Last quarter, Dolphin assessed that when performance pressures lead to a weak market value in the second half of the year, according to NetEase's management's consistent practice, they would increase repurchases or dividends for market value management. For example, when new regulations for online games were suddenly issued in Q4 last year, NetEase ramped up its repurchase efforts and also distributed a substantial special dividend at the end of the year.

It is precisely because NetEase is not short of cash (as of Q3, there was a net cash of 120 billion RMB on the books, an increase of nearly 4 billion RMB quarter-on-quarter) and does not lack the US dollars needed for repurchases, that NetEase can implement strict market value management.

In the third quarter, NetEase repurchased 6.3 million ADS, continuing to double compared to the second quarter. The total expenditure was 569 million USD, averaging 90 USD/ADS. Given the currently low market value, the company is expected to maintain a high level of repurchase.

At the same time, in the third quarter, it announced a dividend of 0.435 USD per ADS, the same as the previous quarter, with a dividend payout ratio of 27% (compared to non-GAAP net profit), remaining stable quarter-on-quarter. Generally speaking, NetEase tends to announce a special dividend in the fourth quarter, thereby increasing the annual dividend level.

Overall, in previous years, NetEase's management generally viewed dividends and repurchases together for shareholder buybacks. Last year, with a strong stock price, repurchases were low, and dividends were raised to compensate. This year, with stock prices under pressure, it is expected that Q4 repurchases will maintain the high levels of Q3, and for dividends, we will first estimate based on the average level of the past three years (i.e., not overestimating the special dividend), so the total dividends and repurchases are expected to reach 20 billion, higher than last year's (17.1 billion), corresponding to a return rate of about 5% based on a market value of 54.2 billion USD as of Thursday's close.